Kill the old, deflation edition

Fantastic article with a clear cut thesis: Japan chooses deflationary policy due to their population demographics. The U.S. can spurn deflation with monetary policy tools the BoJ cannot utilize or does not have.

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FT Alphaville
By: Joseph Cotterill on Sep 09 13:30.

Morgan Stanley economists always have such interestingly contrarian views on the inflation-deflation debate. For example – Joachim Fels’ unfashionably inflationista analysis of central bank credibility.

And now — the deflation-fighting case for Logan’s Run.

Well, that’s our tongue-in-cheek interpretation of Morgan Stanley’s clever argument against deflation becoming a serious threat to the US economy.

Clever (we’re not saying it’s correct) because it sets out to dismantle the foundational analogy for most deflationary anxiety at the moment — the Japanese spectre — and old people have a starring role in explaining why Japan was really rather unique.

According to Morgan Stanley’s analyst (emphasis in original):

The enigma of Japan is not why deflation occurred; that happened for the same reason that deflation is knocking at the door in America and Europe now, i.e. a financial bubble that triggered a deep recession. The enigma is why deflation has persisted. Even more astonishing, Japan nearly escaped deflation around 2006, but then reverted… Whether actively or passively, Japan made a social decision to entrench deflation. Escape was not only possible but was actually within reach in 2006. However, Japanese society decided to return to deflation. Understanding why requires a focus on the institutional structure of monetary policy decisions and social choice…
It includes focusing on the Bank of Japan, notes Morgan Stanley, because the bank has never an explicit inflation target, nor are officials at the BoJ particularly accountable for policies during their term of office. However, Morgan Stanley point out, the law could have been changed to fix this by now.

It hasn’t been. Which is because of a wider social obstacle — old people:

Japan’s population began to age rapidly over 20 years ago… The working age population (15-64) peaked in 1995, at 87.3 mln, and has now fallen to 81.5 mln. Simultaneously, the older population (65+) has risen from 18.3mln to 29.0 mln. The aging of Japan’s population has increased this tendency to favor deflation, because a large share of the population live on fixed incomes. Yes, nominal interest income has fallen sharply with the drop of nominal interest rates. However, complaints about this have largely faded, as pensioners see the benefits of falling prices, relative to their fixed incomes.

The effect is compounded because Japan is now a de facto gerontocracy, according to Morgan Stanley (see chart):



http://av.r.ftdata.co.uk/files/2010/09/Japan_old_II.jpg


These results suggest that the voting structure of the Japanese Diet is heavily weighted in favor of older voters. The key fact for investors comes in the relationship of this over-representation with the economic interests of older voters: Since older voters tend to be pensioners and hold the largest share of financial assets (such as pensions, deposits, and bonds, but hold little in equities), they as a group oppose inflation. Therefore, a legislative system that over-represents older voters is prone to adopt deflationary policies.
Which is all a prelude to Morgan Stanley’s arguing that the United States political economy is better off in both respects. Not only does the Federal Reserve have regard to employment in inflation signalling — encouraging avoidance of deflation– but Ben Bernanke is also regularly hauled before hearing on Capitol Hill.

Above all, American politics isn’t very old — yet

http://av.r.ftdata.co.uk/files/2010/09/US_voter-e1284032403505.jpg

And as Morgan Stanley’s analysts go on to add:

In the House of Representatives (equivalent to the Lower House in Japan), there is virtually no relationship at all between the old/young ratio and the differences of voters/seat. Although there are some wide disparities of representation across states, these disparities are not large and not significantly related to age… there does not appear to be any bias in the Senate in favor of the elderly. Specifically, the most populous state, California, is one of the youngest, the Florida, the fourth most populous state, is among the oldest.
We’ll just pass over the Tea Partiers’ average age…

Far more US government debt is held abroad compared to Japan’s own debt too, Morgan Stanley observes – leaving Japan with the old-people deflation trap and the US with the relative freedom for its authorities to conduct aggressive monetary action.

Note that Morgan Stanley isn’t denying that there are strong deflationary forces acting on the US economy at the moment, especially with private sector deleveraging. Their point is — these are in a sense familiar forces following a debt crisis, rather than Japan’s unlucky, geriatric, combination.

We’ll close with a final point from Morgan Stanley, on investors managing deflation volatility amid all this political economy (emphasis in original):

…the payoff from deflation-inspired investments should be proportional to the risks taken. For example, if there is a 20% chance of deflation, and one invests US$1 on the expectation that deflation will occur, then the payoff if deflation actually occurs must exceed US$5, for the bet to have a positive expected value. Before investing in US Treasuries or European sovereign bonds on the expectation of deflation, it is important to look at the volatility of the bonds, and judge whether the likelihood of deflation justifies the risks. A numerical example may help: In early August this year, a 5yr Treasury had a yield of about 3.00%. A rise of 74bps in market yield would wipe out that return. This 74 bps move was rather small, compared to the 1-year volatility at 97 bps.
Can never be too careful with those old people, though…